Heterogeneous Beliefs about Rare Event Risk in the Lucas Orchard
59 Pages Posted: 23 Apr 2014 Last revised: 18 Feb 2017
Date Written: September 18, 2015
This paper investigates the asset pricing implications of investor disagreement about the likelihood of a systematic disaster. I specify a general equilibrium model with multiple trees and heterogeneous beliefs about rare event risk, to understand how risk-sharing mechanisms affect equity and variance risk premia, at an aggregate level and in the cross-section of stock returns. I identify a state-dependent link between equity and variance premia, that changes with the distribution of agent consumption. Empirically, as in the model, the variance premium's predictive power for future excess returns is greater during times of financial distress, mainly for small stocks.
Keywords: Heterogeneous beliefs, Systemic disasters, Lucas orchard, Variance risk premium, Correlation risk premium, Predictability
JEL Classification: G12, C22, C24, D80
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